China: Failure is an Option

By Ben Levisohn

After suffering losses of nearly 15% in Chinese stocks this year, it would seem hard to say that investors are underestimating the problem’s facing the world’s second-largest economy. They may, however, be doing just that.

Gilles Sabrie

These days, it’s fashionable to take China’s policy makers at their word when they say that they won’t let economic growth fall below 7%. But Societe Generale’s Patrick Legland says investors might be making a mistake if they don’t consider what could go wrong:

While the problems facing the Chinese economy are well documented, we think many investors
may still be relatively complacent about the risk of a hard landing. This could prove a costly mistake. The Chinese economy is still imbalanced: almost 50% of GDP comes from gross fixed capital formation, up from a third in 1997. Massive excess capacity, high and rising corporate debt and an increasingly marginalised private sector are other symptoms of deeply rooted imbalances in China’s economy.

Our China economist Wei Yao believes carefully sequenced reforms should enable Chinese policy makers to mitigate the negative impact of massive resource and credit misallocation. She also believes, however, that there is a non-negligible risk of a hard landing in China in 2013…This is not our core scenario: as noted in the Global Economic Outlook, we believe the Chinese economy will grow by 7.4% in 2013, with growth decelerating gradually to 6% by 2017.

Morgan Stanley, meanwhile, notes that China faces other concerns, including slowing productivity and an aging population:

China is now at a crossroads, facing challenges in its transition toward a new era. The reversal in its demographic tide and slowing in the pace of productivity gains will likely pose headwinds to its potential growth trend. In addition, the over-investment in the past few years has led to excess capacity, and the weakening incremental productivity of credit has increased the concerns about risks to financial stability. These concerns have led policy makers to initiate measures to control credit disbursement. As policy makers attempt to rein in credit growth to bring about deleveraging and reduce the risk of further misallocation in the financial system, there will be a need to remain mindful of the two key challenges of supporting aggregate demand and management of the real rates environment as deleveraging proceeds. These factors will be key to watch to assess if China is able to manage the process of deleveraging successfully.

About Emerging Markets Daily

Emerging markets have been synonymous with growth, but the outlook for individual nations is constantly changing. Countries from Brazil and Russia to Turkey face challenges including infrastructure bottlenecks, credit issues and political shifts. The Barrons.com Emerging Markets Daily blog analyzes news, data and research out of emerging markets beyond Asia to help readers navigate the investment landscape.

Barron’s veteran Dimitra DeFotis has been blogging about emerging market investing since traveling to India and Turkey. Based in New York, she previously wrote for Barron’s about U.S. equity investing, including cover stories and roundtables on energy themes. Dimitra was among the first digital journalists at the Chicago Tribune and started her career as a police reporter at the Daily Herald in the Chicago suburbs. Dimitra holds degrees from the University of Illinois and Columbia University, where she was a Knight-Bagehot Fellow in the business and journalism schools.